Prior to October 2018, entrepreneurs' relief would only apply to an individual's disposal of shares if they held five percent of the company's 'ordinary share capital' and voting rights and were therefore disposing of their 'personal company'. Warshaw held both ordinary and preference shares. If the preference shares were included Warshaw held 5.777% of the company's ordinary share capital. If they were not, his holding was 3.5%. HM Revenue & Customs (HMRC) denied Warshaw's claim on the basis that the company was not his 'personal company'.
The effect of the company's articles was that if there were insufficient reserves to pay the dividends in respect of those shares in a particular year, payment would be deferred to a subsequent year. Therefore, the fixed rate at which the dividend would be paid (ten percent) would be calculated on an increased amount.
Ordinary share capital is defined for the purposes of entrepreneurs' relief as “all the company’s issued share capital (however described), other than capital the holders of which have a right to a dividend at a fixed rate but have no other right to share in the company’s profits”. Since both parties agreed that the shares gave a right to a dividend and no other rights to share in the profits, the issue considered by the tribunal was whether the preference shares did or did not carry a right to a dividend at a fixed rate.
HMRC argued that despite the compounded element on which the dividend would be based being variable under the company's articles, the shares carried a right to a dividend at a fixed rate and were therefore not ordinary share capital.
The tribunal found in favour of Warshaw, holding that whether there is a right at a fixed rate is not determined on the basis of what dividends actually accrue but instead depends on the rights accorded to the shares in the company's articles. In this case, the computation of the dividend could be a varying amount depending on the level of the company's distributable reserves and could therefore not be said to be fixed.
"The case does not sit comfortably with guidance recently published by the Chartered Institute of Taxation and agreed by HMRC. That guidance asserts that cumulative preference shares would not be ordinary share capital, although the examples provided in respect of this point have been caveated as 'finely balanced and subject to review," Peter Morley said.
HMRC has since provided clarification on their interpretation of cumulative preference shares following the case in an update to the Company Tax Manual. They consider that in order for cumulative preference shares to be ordinary share capital there must be a further rate of interest added.
"The decision will then turn on whether the additional interest is seen as a return on the original investment, suggesting fixed rated, or whether it is seen as a separate return on amounts outstanding, with a right to two differing fixed rates and therefore non-fixed," Morley said. "The HMRC guidance states that the case is 'of persuasive rather than precedent authority' and it seems likely that the decision will be appealed to the Upper Tribunal."